Don’t fight the forces, use them. – R. Buckminster Fuller
Everyone thinks that due to the recent events caused by Coronavirus we are in uncertain times. I believe we are always in uncertain times. The emergence of any event has multiple co-dependent factors and nothing gets created out of a vacuum. Since we cannot know and control all the factors that lead to the manifestation of any situation; we cannot be 100% certain about any event. Thus, we are always in uncertain times, only the degree varies in our mind based on how we perceive the latest set of information which has known ‘knowns & unknowns’ and still missing out on unknown ‘knowns & unknowns’.
The best investors I know are those who believe that the future is always uncertain and they plan and account for such a situation in their investment management framework. The investors who do poorly are those who are always very sure of the future events. In this blog, I am going to give you insights on the important aspects of investment management employed by the best investors and how we can use them to maximize our portfolio returns besides minimizing the risk.
1. Be Cautiously Optimistic
We all know that to be able to be successful in life, we must be optimistic about our future. However, along with that optimism, caution should also be attached due to unknown ‘knowns & unknowns’ in the future. The best investors are cautiously optimistic about the future. In fact, Warren Buffet who is the 4th richest man in the world has two rules for investing:
Rule No 1: Never lose money
Rule No 2: Never forget rule no. 1
The above statement doesn’t mean that one will never have investment losses but following the above two rules will make you think in a direction to build strategies and approaches that minimize your losses.
Did you know many of the world’s best investors were already prepared for the crash? Warren Buffet is sitting on more than USD 120 billion of cash from many months, Howard Marks has been talking about being defensive since the last two years and so was Seth Klarman. It’s not that they knew the time of the market crash, but their investment strategies ensured that their portfolios were prepared for any such eventualities.
They understand that stock markets go through a cycle and the valuable lessons from history taught them to read signs and stay cautiously optimistic. They don’t fight the forces, they use them.
2. Use tactical allocation to make your portfolio future-ready
Smart investors are very careful about market valuations (prices) and investor behaviour. They know that human behaviour leads to extreme prices in the stock market – both on the upside and downside, and they are prepared to take advantage of such follies. The chart below illustrates that the smart money enters when valuations are low and the majority of the investors aren’t looking at that asset class or security.
How are they prepared for that? They use the principle of margin of safety. It means they buy any business or stock when its trading price is lower than their self-assessed fair value (also known as intrinsic value) of that business. Lower the trading price than fair value, lower is the downside risk and higher is the margin of safety and upside potential. Similarly, the smart investors stop making new investments and sold the one they were holding when they realize that market valuations are too expensive which results in higher downside risk, low margin of safety, and lower return potential. This provides them enough liquidity to invest again at cheaper prices when the tide goes out.
For common investors, arriving at a fair value of any stock could be very tricky. Hence, they can use a simple valuation parameter of 10-15 years average price per earning (PE) ratio. For example, the 15 years average twelve months trailing (TTM) PE ratio of benchmark Sensex is 18-19x. In previous market cycles, the TTM PE of Sensex has touched 28-30x at the market peak and 10-12x at the marker trough. So a mutual fund investor focused on large caps should gradually start reducing equity allocation from the portfolio as it keeps rising above 21x PE. On the contrary, one should gradually add up equity allocation as the Sensex PE keeps falling below 18x PE ratio. A sample tactical allocation plan for an investor with a moderate risk profile could be like this:
Please note, we have simplified the above case for understanding purposes. In reality, fair valuation of the Sensex depends on many factors and it keeps on changing but taking long term average (of at least 10-15 years) is a good way to start. The important takeaway is that there should be an allocation plan prepared for asset class volatility and it shouldn’t be just an ad-hoc emotional buying or selling. One can prepare a customized plan depending upon their investment liking and understanding of different asset classes, sub-categories, and their own risk profile. Having a sense of market/asset class cycles and at which stage we could be in that cycle helps tremendously.
Now let’s see how tactical asset allocation can make a huge difference in your portfolio performance. Consider an investor with a high-risk profile who chooses to take equity exposure in her portfolio by investing in an index fund tracking Sensex and the remaining amount in a debt mutual fund. She had a plan to reduce equity exposure to 40% of the portfolio when the Sensex TTM PE reaches 26x and increase it back to 100% when the Sensex TTM PE reaches 13x. If she had executed her plan with perfection in two years period from Oct 2007 to Oct 2009, her portfolio returns would have been positive 31% (46% more than Sensex returns) over the next two years compared to negative 15% returns if she had continued to stay 100% invested in equity.
Pardon me for using a perfect case scenario for a short period of two years to drive across my point for the sake of calculation simplicity. In reality, the best strategy is to gradually increase equity allocation as the market continues to slide down since you never know if the market will really bottom at 13x or 14x or any other PE ratio. You would have still ended up making 20-25% higher returns over the Sensex returns in two years by making staggered investments during the down cycle. Series of such successful tactical asset allocation calls results in long term compounding returns and outperformance over the benchmark returns by 5-15% per annum which is just amazing!
There are various studies which explain that asset allocation accounts for 80-85% of portfolio returns while scheme selection contributes to only 15-20%. Despite that, many investors end up spending a majority of their time and energy in finding the best scheme and rarely on finding the best asset allocation.
However, having a plan is not the sure shot way to investment success if you do not have the right temperament and courage to execute the same. This brings us to the last but the most important quality of successful investors.
3. Patience, Courage, and Conviction
Since patience and courage are rare traits, so is the rare club of successful investors. I have seen many disciplined and experienced investors who resisted investing in equity for a long time due to expensive valuations but finally gave in to the psychological pressure of seeing their peers make money. They ran out of patience and ended up investing at the market peak. They find some reasons to justify the excessive valuation by assuming that the factors that are driving the market to excesses will continue to stay perpetually. By the way, bears turning bulls is also a strong signal of market reaching to its peak.
Having conviction to follow a strategy and patience to stick to a plan (usually by going against the herd) for as long as it requires, needs a great strength of courage and tranquil temperament. One can develop and strengthen these qualities by meditation and practicing mindfulness.
Downside of following a disciplined value investing approach is that you may end up being too early sometimes. But it is always better to be early than late. Being early can cost you some missed-upside but being late is very dangerous to your portfolio health.
We hope this piece helps in understanding on how to formulate an investment strategy for your portfolio. You must work on a plan immediately even if your portfolio has losses. Failing to plan would lay ground for future disappointments. If you are having difficulty in setting up a strategic investment plan that suits your unique requirements, feel free to discuss with us.
Truemind Capital is a SEBI Registered Investment Management & Personal Finance Advisory platform. You can write to us at email@example.com or call us on 9999505324.